Newport Mining has a lease with two years remaining in
Newport Mining has a lease, with two years remaining, in which it can extract copper ore on a remote island in Indonesia. The company has completed the exploration phase and estimates that the mine contains 5 million pounds of ore that can be extracted. The ore deposit is particularly rich and contains 37.5% pure copper. Newport can contract with a local mining company to develop the property in the coming year at a cost of $ 1.2 million. Three-fourths of the cost of development must be paid immediately and the remainder at the end of one year. Once the site is developed, Newport can contract with a mine operator to extract the ore for a cash payment equal to $ 0.60 per pound of ore processed or $ 1.60 per pound of copper produced. 11 The total cost must be paid in advance at the beginning of the second year of operations. This amounts to a cash payment in one year of $ 3 million. At the end of one year, Newport can contract to sell the copper ore for the prevailing spot price at that time. However, because the spot price at the end of the year is unknown today, the proceeds from the sale of the refined copper are uncertain. 11 Because
The current price is $ 2.20 per pound, and commodity analysts estimate that it will be $ 2.50 a pound at year-end. However, because the price of copper is highly volatile, industry analysts have estimated that it might be as high as $ 2.80 or as low as $ 1.20 per pound by the end of the year. The price of copper is expected to stay at $ 2.80 or as low as $ 1.20 throughout the second year. As an alternative to selling the copper at the end-of-year spot price, Newport could sell the production today for the two year forward price of $ 2.31 and eliminate completely the uncertainty surrounding the future price of copper. However, this strategy would require that the firm commit today to producing the copper. This, in turn, means that Newport’s management would forfeit the option to shut down the plant should the price be less than the cost of producing the copper. Given the risk inherent in exploration, Newport requires a rate of return of 25% for investments at the exploration stage but requires only 15% for investments at the development stage. The risk-free rate of interest is currently only 5%.
a. What is the expected NPV for the project if Newport commits itself to the development, extraction, and sale of the copper today and sells the copper in the forward market?
b. What is the NPV of the project if the production is not sold forward and Newport subjects itself to the uncertainties of the copper market?
c. Using the decision tree on page 484, construct a diagram that describes Newport’s payoff from the investment that includes the option to extract the ore at the end of one year.
d. What is the lease worth to Newport if it exercises its option to abandon the project at the end of year 1? Should the firm proceed with the development today?
e. If Newport decided to extract the ore itself, how could it use the copper call options to hedge the risk of mining for the copper? The price of a European call option on one pound of copper with an exercise price of $ 1.68 and maturity of two years is $ 0.70.
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